What is the difference between Class A, B, and C properties?
The commercial real estate industry uses a lot of lingo. This can seem daunting for first-time investors looking to make sense of different property types.
One of the ways to distinguish amongst property types, for instance, is by a property’s “class” rating. Generally speaking, properties are classified as either Class A, Class B, or Class C properties. This is true across all real estate asset classes, regardless of whether you’re referring to office buildings, retail centers, apartment buildings, or industrial and warehouse facilities.
With our expertise in transforming distressed commercial buildings into valuable assets, we are experts in determining the value of Class A, B, and C properties for your investment portfolio. Here is Feldman’s guide to the ABCs to property types and when you should invest in each.
Although there is no universally-accepted definition of a Class A (or Class B or Class C) properties, most in the industry consider Class A buildings to be newer with higher-quality finishes, amenities and accessibility. Class A properties tend to be located, and oftentimes have their own brand or lifestyle associated with them.
Class A properties tend to be extremely desirable, investment-grade properties with the highest quality construction and workmanship, materials and systems. They often contain unique architectural features, utilize the highest quality finishes, and utilize first rate maintenance and management. Class A properties are also distinguishable by the tenants they attract. Most Class A properties will be occupied by prestigious, credit-worthy tenants that are willing to pay above average rental rates on longer term leases. Class A properties are frequently bought and sold by national and international investors, including institutional investors such as life insurance companies and pension funds, who are willing to pay a premium for quality assets.
Example of a Class A property
An example of a Class A property would be a newly-renovated office building located in downtown Tampa, Florida, such as the Wells Fargo Center. The property is located close to the waterfront with great views, in a premier location that makes it easy to attract best-in-class tenants. The property is considered highly sustainable (LEED Gold-certified) and has been designed with resiliency in mind. The property also contains robust technology to provide building-level cooling systems to provide the highest level of comfort for the office workers inside. The office building also offers robust amenities, such as a ground-floor café, restaurant, coworking space, bicycle storage, on-site showers and a full service fitness center, and valet service for the parking garage.
Benefits of a Class A property
There are several benefits to owning or investing in a Class A property. The most obvious benefit is the ability to attract high-quality, credit-worthy tenants that are willing to pay higher rents. The desirability of Class A buildings means that they provide more liquidity than Class B or Class C properties. In other words, there is enough consistent interest in purchasing Class A properties that an investor can expect to have an easier time selling the property than if they were trying to sell a Class B or Class C property in the same market.
For all of these reasons, Class A properties are considered to be one of the “safest” additions to an investor’s portfolio (but conversely, offer somewhat lower returns in exchange for this lower risk profile).
In fact, a recent study by the MIT Center for Real Estate finds that over the course of a market cycle, Class A properties located in secondary markets (e.g., Atlanta, Miami, Dallas, Houston, Phoenix, Denver, San Diego, Seattle, Minneapolis) outperform Class B properties in primary markets (New York, Los Angeles, Chicago, San Francisco, Boston, and Washington, D.C.). This, the study found, was true when evaluating both office buildings and multifamily properties.
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What is a Class B property?
A Class B property tends to offer more utilitarian space with fewer amenities than one would find in a Class A building. It will typically have ordinary architecture design and structural features, with average interior finishes, systems, and floor plans. The systems will be in adequate condition and the property will be structurally sound, but not overwhelmingly impressive. Generally speaking, the older the property is, the more likely it will the designated as a Class B property. However, there are examples of older buildings that maintain a Class A designation.
The maintenance, management, and tenants in a Class B property are considered good (but not necessarily great). Class B properties may also be less appealing to tenants, in general, as the buildings may be deficient in a number of respects, such as ceiling heights and building or facility condition. Tenants that leased space in a class B building tend to be be less established, have lower credit, or may be unable or unwilling to sign a long-term lease. Therefore, while Class B buildings tend to attract broad interest among a wide range of users, the rents these tenants are willing to pay tends to be less than a Class A property can command.
Class B properties are often considered more of a speculative investment than their Class A counterparts. Class B properties will occasionally attract attention among national investors, but most investors tend to be local to the marketplace.
Example of a Class B property
An example of a Class B property would be a 20-year-old office building located in an urban location that has fair to good visual appeal. The office property may be located in an acceptable neighborhood but it is not likely to be the highest rent location. The building may provide ample on-site parking, have functional HVAC systems, and acceptable management. However, the building lacks the robust amenities found in today’s newly-build Class A office buildings. For example, the lobby may not have been renovated in many years and they look “dated”. Many of the suites in a Class B building have floorplans that need to be reconfigured to meet the needs of today’s workplace (e.g., open offices with fewer private offices, high ceilings, smaller work stations, etc.). This property may have been considered Class A when it was first constructed but has since been reclassified as Class B given an influx of new office product in that same market.
Benefits of a Class B property
While Class B properties tend to be considered a “riskier” investment than Class A properties, there are still several benefits to adding a Class B building to your portfolio. Namely, well-located Class B properties can generally be purchased at a lower price (and therefore, have a lower barrier to entry), and in some cases can be renovated to Class A condition over time providing opportunities for value-add sponsors. As building improvements are made and leases turn over, the new owner can increase rents and improve the tenant mix. With thoughtful value-add strategies, an investor can realize greater returns through Class B properties than they might be able to achieve by investing in Class A buildings in the same market.
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What is a Class C property?
A Class C property is one that is older (typically 30+ years old), in fair to poor condition, and typically not as well-located as a Class A or Class B building. They are considered to be the “riskiest” investment, but in turn, offer some of the best potential cash-on-cash returns.
Class C properties are not for the faint of heart. Although acquisition costs may be lower, the properties often have deferred maintenance, high tenant vacancy rates, low existing cash flow, and few amenities that can be monetized or marketed to prospective tenants. As such, Class C property investors will typically need to make significant capital investments upon purchase and will usually need high maintenance reserves in the event further repairs and improvements are needed. That said, while Class C properties typically command lower rents than Class A and Class B properties, they are usually marketable to a wide range of users. A no-frills Class C office building, for instance, may be easily converted to flex space to accommodate a lab company looking for office and R&D capabilities.
An example of a Class C property is a four-story office building originally constructed in 1918 but which has not experienced a major renovation since the late 1970s. The building’s infrastructure is outdated (including electric capacity, HVAC, and telecommunications equipment). There are only two elevators and limited on-site parking. The existing owner has not been investing in tenant improvements as leases turn over, and as a result, the office spaces are unimpressive and trending toward obsolete. Typically, Class C buildings are not located in the higher rent districts.
Benefits of a Class C property
Class C properties may be considered the least “desirable” type of property, from both an investor and tenant perspective—but should not be written off entirely. In fact, Class C properties represent a significant value-add opportunity, particularly if otherwise well-located. For example, an investor might purchase and then immediately renovate a Class C office building. The renovation might include gutting the interior lobbies and common areas, including elevator landings, circulation corridors, etc. An extreme makeover might include adding a new skin to the building façade. The interior is reconfigured to add amenities, such as an on-site gym, café, and renovated building lobby. Essentially, the property will have been repositioned from a Class C building to one solidly Class B, even Class A-.
Acquisition Cost: Class A properties are typically the most expensive to purchase, and therefore, often have the highest barrier to entry. Few people have the means to purchase a Class A property outright, which means investing in a Class A asset will typically require finding other equity investors. Meanwhile, smaller Class B and Class C properties tend to have lower acquisition costs, and therefore represent an opportunity for an individual investor to acquire the property without taking on outside investors.
Desired Rate of Return: Class A properties typically have a lower rate of return than Class B or Class C properties, which are riskier but tend to have higher cap rates, cash-on-cash returns, and total cash flow. Class A properties will usually have more appreciation potential, but if an investor is looking for more immediate returns, they may want to consider investing in Class B or Class C properties for their cash flow potential.
Risk Tolerance: The most risk-adverse investors will want to buy Class A properties. These properties are in the best condition, usually ieasily leased to high-quality tenants, and are usually in the best locations. Therefore, these properties are considered to have more liquidity than Class B and Class C buildings and can more easily be bought and sold, regardless of where we are in any given market cycle.
It is important to understand that this classification is meant to be a guide, and that in practice, property classifications are not as cut and dry. Properties often fall within these extremes, based on condition, amenities, tenant mix, or location and subjective opinion. It’s all relative.
Let’s consider the example of the Wells Fargo Center, constructed in 1985, and one of the portfolio buildings that we own and operate in our Tampa portfolio. The 22-story property is located on the waterfront and has been impeccably maintained. The lobby has been beautifully renovated, and amenities have been added over time. By most standards, this would be a Class A office building given its condition and location (despite its absolute age).
However, a new office building is under construction nearby, and that project will include state-of-the-art equipment, technology, and modern-day workforce amenities. When this building comes online, our property, constructed in 1985, could drop in status from Class A to Class B+ essentially overnight. However, the 1985 office building, due to its extensive renovation and best-in-class management will remain a premier office property that creates superior risk-adjusted returns for its owners.
In other words, consider property classifications to be more of an art than science. There are several variables that can impact the desirability of a property, and these should be evaluated as a whole, and in context of the local market, rather than in reference to a subjective classification system that assigns properties Class A, B, or C-status.
Real estate investors often look at the highest IRR when comparing one investment to another. But, in commercial real estate, such criteria is potentially short-sighted. Instead, investors should be evaluating commercial real estate opportunities by looking at their risk-adjusted returns – not just the overall IRR.
Most real estate investors understand the value of a good property manager as a key member of their team.
Do-it-yourself (“DIY”) property management is way too time-intensive for serious investors. That time is better spent finding more deals. Even if you make a little less money each month by paying some of your gross income to a property manager, you could end up purchasing five, ten, or twenty properties with a fraction of the effort.